Emerging-market bond funds outdo stock rivals

MurrayColeman

SAN FRANCISCO (MarketWatch) -- Emerging-market stocks have been sinking, reflecting concern that the global economy is slowing, but the bonds of these developing nations are showing strong resilience.

Diversified emerging-markets bond mutual-funds are up 1.3% on average this year through Thursday, while their stock-focused siblings are 2.4% in the red, according to investment researcher Morningstar Inc.

"The rally in U.S. Treasurys is supporting emerging-markets bonds," Brett Diment, lead manager at DWS Emerging Markets Fixed Income Fund
SZEAX, -0.23%
said. "A lot of debt in overseas countries can be purchased in dollar-denominated notes these days."

Since late January, 10-year Treasury yields have taken a slight fall, boosting prices. Similarly termed emerging-market bond yields also declined in that time, although not as much. As a result, spreads between the two types of bonds have widened to around 2%.

Historically, that's on the lower end of the range between emerging-markets and Treasury debt. Two years ago, for example, spreads were around 3.5%. In March 2002, that gap was close to 6%.

"The spread should continue to narrow," said Diment, who heads the emerging-markets team at Aberdeen Asset Management, which runs the DWS fund and manages about $3 billion in emerging-markets debt for institutional and retail investors.

Spreads between emerging debt markets and U.S. Treasurys to narrow to around 1.5% in the next 12 months, Diment predicts.

"We're seeing a structural change in the market," he said. "Countries are buying back their external debt, which is largely denominated in dollars."

Credit improves

For a country like Brazil, such moves have made many emerging-markets net creditors. As a result, analysts believe some Latin American countries might receive upgrades to investment-grade credit ratings. These include markets such as Brazil, Peru, Colombia and Panama.

"The most likely to be upgraded in the next 12- to 18-months is Peru," said Matthew Ryan, lead manager at MFS Emerging Markets Debt Fund
MEDAX, +0.07%
"Colombia and Panama are also doing a good job in terms of reducing their budge deficits and debt-to-GDP ratios."

With its huge oil and gas resources, Russia's debt was upgraded to investment-grade several years ago. In the future, some other candidates are the Philippines and Indonesia, Ryan says.

Both Diment and Ryan are investing in Turkey, where presidential elections are slated for May and Parliament must hold its vote by winter "We could see a bit of turbulence around those periods," Diment said. "But it shouldn't change the country's fundamentals."

Underpinning Turkey's prospects are declining inflation, which could lower short-term interest rates. Government bonds denominated in liras yield 18.5%. Diment is expecting that will fall to around 16% in the next 12 months. Meanwhile, inflation is currently running in the double-digits but is projected to drop nearly in half in coming quarters, Diment says.

Less volatility is expected in Brazil's debt market. "They're a high-yielding country which also has strong fundamentals such as a good current account surplus," Ryan said. "Other high-yielding emerging-markets such as Turkey and South Africa have current account deficits."

Yields on the intermediate end of the Brazilian debt curve are down slightly from a year ago to around 6% in U.S. dollar terms. "It's a fairly stable market but there's not a lot of juice left in terms of upside," Ryan said.

But he sees that as a long-term positive. "We're seeing a real role reversal where the developing markets are funding the debt of developed markets around the world. Emerging-markets as a whole have current-account surpluses and restructured economies that we think should provide sustainable growth rates through this year," Ryan said.

At GMO LLC, fund manager Bill Nemerever is expecting around 5% growth in total returns for emerging-markets bonds in 2007. That would be down from last year's near double-digit gain.

"The slowdown is partially a result of the fact that the quality of debt is higher in these markets now," Nemerever said. He pointed out that higher ratings for emerging-market bonds means "issuers don't have to offer as high of rates as they once did," to investors.

Currency deals

But deals are still around, says Chris Dillon, bond portfolio specialist at T. Rowe Price Group Inc.
TROW, -0.25%
He says on first blush, emerging-markets debt might seem somewhat pricey. But much of those seemingly steep valuations, adds Dillon, come from comparisons of issues in dollars rather than local currencies.

"Emerging-markets debt indexes are primarily U.S. dollar denominated," he said. "So their valuations at this point tend to be pretty high."

Managers and analysts at the Baltimore-based fund giant are buying in local markets, taking advantage of more favorable currency rates in some cases.

"That's where we're seeing a lot of opportunity these days," Dillon said. "In Brazil, for example, you can invest in U.S.-dollar denominated issues or debt issued in the local currency. We're finding good fundamentals in debt issued in the [Brazilian] real, yielding in excess of 10%."

Eastern Europe is another area that T. Rowe Price's bond-fund managers favor on a long-term basis. They've been investing in Serbia, for example, since 2002. The country has a current accounts surplus and a growing economy, Dillon says. "People who left Serbia for places like the U.S. have been sending a lot of money back into the country to relatives and friends," he said. "That has been a very positive factor to go along with that market's general economic strength."

Bob Kowit, head of international fixed income at Federated Investors
FII, +0.48%
is also finding more value buying emerging-markets debt issued in local currency.

"Since the beginning of the year, the Mexican peso has declined in value against the dollar by about 2%," he said. "Even with that decline, you're still getting a yield of around 6% on an annualized basis for government long-termed debt. That's a couple of percentage points better than what you'd get in the U.S."

Roberto Sanchez, a Federated Investors portfolio manager, adds that current conditions shouldn't blur investors' reasons for buying emerging-markets bonds. Fundamentals are in place for future growth as well, he said.

"In emerging-markets, savings rates are running in the 15% to 25% range of income levels," he said. "That's why we're expecting in coming years to see a lot more insurance products, mutual-funds and funded pension plans in developing parts of the world."

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